The ABCs of MLPs

05/14/2013 7:45 am EST

Focus: MLPS

Here's a comprehensive explanation of Master Limited Partnerships and the benefits and drawbacks for investors, courtesy of Chloe Lutts of Cabot Wealth Advisory.

One of the highest-yielding investments we regularly recommend are master limited partnerships, or MLPs. MLPs are similar to a "regular" limited partnership, with a few differences.

MLPs are publicly traded, obtaining capital from limited partners (unitholders) who get a share of its cash flow in return. A general partner runs the business.

The primary benefit of being organized as an MLP is that the business doesn't pay corporate taxes on its revenue. Instead, the cash flow is distributed almost entirely to the unitholders (who are then responsible for taxes). They often make large regular distributions, and have very high yields.

The tax code requires MLPs to derive about 90% of their revenue from natural resources, commodities, or real estate. In practice, many own energy transportation or processing facilities, like oil or gas pipelines.

Because MLPs don't pay taxes at the corporate level, you will owe tax on any MLP distributions you earn. But the distributions are heavily tax-advantaged, with most of your tax burden deferred until you sell the MLP. Here's how it works.

MLP distributions are made based on the MLP's distributable cash flow (DCF), which is similar to free cash flow (FCF). An MLP's DCF is usually much higher than its net income because MLPs have significant depreciation and other tax deductions, which lower their taxable net income significantly. (This is why certain types of businesses make better MLPs: huge tangible assets like oil pipelines have very high depreciation expenses.)

So the money comes in, the MLP pays it out as distributions to the unitholders, then the MLP takes deductions on the amount and reports its taxable net income to the government. You only owe taxes on the portion of your distribution that came from the MLP's net income-which will be reported on an annual form called a K-1.

You have to pay regular income taxes on that portion of the distribution (not the lower qualified dividend tax rate), but it's usually only 10% to 20% of the total distribution. The other 80% to 90% of the distribution is considered "return of capital," and reduces your cost basis in the MLP.

You have to pay regular income taxes on the difference between your original purchase price and your reduced cost basis when you sell the MLP (at the same time you pay taxes on your capital gains), but in the meantime, those taxes are deferred. That's a big benefit to many investors who want to focus on reducing their current tax liability on their investment income.

Plus, the cost basis of the investment is "reset" to the current market value if the original unitholder dies and passes on the investment. So the new owner won't owe tax on the difference between the original cost basis and the adjusted cost basis.

While you are allowed to hold MLPs in a tax-advantaged account like an IRA, it is unwise. The IRS considers MLP distributions paid into an IRA "unrelated business taxable income," or UBTI. And if your IRA earns over $1,000 in UBTI (total from all sources, including distributions from different MLPs) in a single year, your IRA will be liable for paying tax on that income, at corporate tax rates.

However, if you do most of your investing through an IRA and would like to add the yield-boosting powers of MLPs to your account, there is a way. Funds that specialize in MLPs have given investors a way to benefit from the income-generating power of MLPs without dealing with K-1 forms and UBTI liability.

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